Recovery of depreciation on rental property

Rental property depreciation recovery refers to a tax provision on capital gains due to depreciation commonly faced by real estate investors who sell their rental income property.

In essence, depreciation recovery is how the Internal Revenue Service can “recapture” taxes on all or part of the gain on the asset’s disposal as ordinary income, rather than solely as capital gain ( which is often at a lower rate). ).

Supply is far from simple. In fact, determining the amount subject to recovery is typically characterized as one of the most confusing income tax responsibilities faced by real estate investors selling rental properties. Mainly because the specific rules are detailed and subject to change.

So the following article is intended to help you understand the general concept of depreciation recovery only. Investors should always consult qualified legal and tax advisors when making any real estate investment decision.

Okay, let’s go through the process from the beginning.

The depreciation allowance (or “cost recovery”) is one of the biggest tax deduction advantages the IRS gives owners of rental properties over the life of their ownership.

Under the current Internal Revenue Code, from the time the property is placed in service until the time title is transferred or the depreciation limit established by the IRS is reached, investors may deduct an amount for recovery of costs each year on physical structures (called “improvements”) as an income tax deduction.

The amount of that annual deduction is determined by the “useful life” of the asset as specified in the code. Currently the useful life of residential rental property (buildings occupied by tenants as housing) is 27.5 years and non-residential rental property (buildings occupied for commercial purposes) is 39 years.

For example, let’s say you buy an apartment complex for $800,000, of which 70% is for physical improvements. According to the IRS you would have a “depreciable base” of $560,000 (800,000 x.70) which you can depreciate according to its useful life. By dividing that depreciable basis by the useful life (560,000 / 27.5), you establish that you can claim a cost recovery deduction to offset your taxable income each year in the amount of $20,364.

Please note that both the year of acquisition and the year of sale would compute a slightly different amount due to the “mid-month convention” provided by the tax code. In the real world, of course, this convention would be considered, but for our purposes the convention is ignored just to keep it simple.

That seems fine to me. So let’s continue to show you why the feds stepped in with depreciation recovery and created IRS Code Section 1250.

Since the taxpayer earned a benefit by offsetting ordinary income from owning a depreciable rental property, the IRS concludes that the taxpayer must repay that benefit when the property is sold.

Let’s consider an example to give you the idea. Suppose you sell your investment real estate at the end of five years for $900,000. This is how the Internal Revenue Service determines your gain on the sale.

1. First, the total amount of deductions claimed during the holding period is calculated by taking your annual depreciation deductions times the number of years claimed (20,364 x 5), or $101,820.

2. Second, your property’s “adjusted basis” is calculated by reducing your original basis (purchase price) by the amount of deductions you claimed (800,000 – 101,820), or $698,180.

3. Finally, your “gain” is calculated by subtracting the property’s adjusted basis from its sales price (900,000 – 698,180), or $201,820.

It is worth noting how the IRS benefits from this method. For example, if your profit on the sale was simply calculated as the selling price minus your original basis (900,000 – 800,000), your profit would be $100,000. In this case, however, your profit increases to $201,820, which is which means the IRS can tax you on an additional $101,820.

Okay, now let’s consider how taxes are collected.

Since capital gains income tax is often less than ordinary income taxes, rather than simply taxing the investor’s full amount at the capital gains rate, the IRS applies depreciation recovery. This allows them to take the full depreciation deductions claimed by the investor back to income and tax it as ordinary income.

Is that how it works.

Depreciation deductions of $101,820 taken by the real estate investor are taxed at the cost recovery recovery tax rate, and the remaining $100,000 (201,820 – 101,820) is taxed at the capital gains rate.

For example, if the recapture tax rate is 25% (the maximum allowed) and the capital gains tax rate is (say) 20%, then because of the sale, the taxpayer owes the feds $25,455 (101,820 x .25) plus $20,000 (100,000 x.20), or $45,455.

Of course, this tax method of recovering depreciation can cause a significant tax impact for real estate investors selling rental properties. Consider this in conjunction with the illustrations above to see what I mean.

Without any consideration for depreciation deductions, the investor’s tax liability at the time of sale would be calculated simply as the sales price less the purchase price (900,000 – 800,000), or $100,000 taxed at the capital gains rate (100,000 x.20), or $20,000.

While with this consideration, the investor’s liability to the IRS is based on an increase in profit caused by depreciation deductions and then partially taxed as ordinary income and capital gains, which, as we illustrated, results in a liability tax of $45,455. In other words, the real estate investor’s obligation with internal income by this method is increased by $25,455.

That’s fine, but even if we assume the highest adjusted profit of $201,820, we can still see how the depreciation recovery affects the investor. Without it, the investor’s liability to the IRS would be based on that total amount taxed only at the capital gains rate (201,820 x.20), resulting in a tax liability of $40,364. However, if partially taxed as recovery and the remainder as capital gains, the liability becomes $45,455 (an increase of $5,091).

Just one more thought and we’re done.

Several conditions must be met at the time of sale of a rental property for the depreciation recovery tax to apply. The tax event takes place only at the time the asset is disposed of. Second, depreciable real estate must be sold after one year of ownership; otherwise, they are considered short-term capital gains and no catch-up is applied. Third, the investor must prove a gain recognized as a result of the sale (there is no recovery when the taxpayer assumes a loss). Fourth, the amount subject to recovery cannot exceed the realized gain and cannot exceed a 25 percent tax rate.

Here’s to your success in real estate investing.